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Monday, October 15, 2012

Individual Investors Can Easily Beat the Performance of Professional Money Managers ... It's a Simple Formula

Harvard, Yale and others have huge endowment funds in the billions of dollars. They also have access to the world's leading professional hedge fund and other money managers.

But ordinary individual investors are likely to achieve better investment performance over time just by sticking to a DIY low cost buy and hold strategy with a mix of stocks to bonds of 60/40. For the more venturesome, owning all stocks would be even better.

"For years, America’s largest, richest and most prestigious universities
have been the envy of investors. They churned out double-digit returns
over the last two decades, even with steep losses during the financial
crisis. Harvard’s endowment today is over $30 billion and has generated
annualized returns of 12.5 percent over the last 20 years.

Their investing success along with their vaunted academic reputations
led many financial experts to conclude that Harvard and its peers at the
pinnacle of higher education had solved an age-old conundrum: how to
generate higher returns with lower risk. . . .

College and university endowment returns for the most recent fiscal
year, which ended June 30, are starting to roll in. And in many cases,
they warrant a grade of “C” at best, and in some cases, an “F.” Harvard
reported a 0.05 percent loss and a drop in its endowment of over $1
billion in the same period, even as a simple Standard & Poor’s 500
index fund gained about 5.5 percent....

Even more startling, data compiled
by the National Association of College and University Business Officers
for the 2011 fiscal year (the most recent available) show that large,
medium and small endowments all underperformed a simple mix of 60
percent stocks and 40 percent bonds over one-, three-and five--year
periods. The 91 percent of endowments with less than $1 billion in
assets underperformed in every time period since records have been
maintained. Given the weak results being reported this year, that
underperformance is likely to be even more pronounced when the fiscal
year 2012 results are included. . . .

“The compelling simplicity of a 60/40 strategy is very hard to beat,”
Timothy J. Keating, president of Keating Investments in Greenwood
Village, Colo., and author of two reports on endowment performance, told
me this week. “Many investors would be much better served with a simple
60/40 strategy, or at least a core where you have low-cost index funds.
When you understand the role of transaction fees, it’s a very high
mountain to scale.” . . .

Simon Lack, a founder of SL Advisors in Westfield, N.J., and a hedge
fund insider — he allocated capital to hedge funds during his 23 years
at J.P. Morgan — caused a stir earlier this year with his book, “The
Hedge Fund Mirage,” in which he calculated that the hedge fund industry
as a whole lost more money in one year (2008) than it had made in the
previous 10 years. “If all the money that’s ever been invested in hedge
funds had been put in Treasury bills
instead, the results would have been twice as good,” he asserted. And
he maintained that nearly all the hedge funds’ gains had gone to hedge
fund managers rather than clients.

“If you look at the data, hedge funds have underperformed a simple 60/40
stock/bond mix every year for the past 10 years,” Mr. Lack told me this
week. “They did well in the downturn of 2000-2. But that’s when assets
under management were less than half what they are now. There’s no
disputing that as assets have grown, performance has declined.” . . .

Among those raising questions about the Ivy League model and its heavy
dependence on alternative investments is Vanguard, the giant mutual fund
company that has long promoted a radically simpler approach based on
low-cost index and mutual funds. “I feel that there was endowment envy,
or maybe emulation is a better word,” Francis M. Kinniry Jr., a
principal in Vanguard’s Investment Strategy Group, told me this week.
“Everybody wanted to look like the Yales and Harvards of the world. But
they were early. They were doing these techniques in the mid-1990s and
late 1990s when equities looked overvalued, and alternative strategies
could capture market imperfections. That’s no longer true. Those
universities were forward-looking and deserve a lot of credit. But
emulating that process three, five or seven years later is very
problematic.”"

Summing Up

Stocks outperform other investment vehicles over any extended period of time. As an example, there has never been a 30 year timeframe when bonds have beaten stocks.

Of course, stock prices change by the moment and price volatility is ever present. We just have to get used to that.

So if we buy shares of good companies, hold on to those shares (and in taxable accounts minimize the payment of capital gains taxes), pay virtually no management fees in our DIY buy-and-hold portfolio and make sure not to get overly excited about the short term ups and downs of share prices, we'll do better than most professional money managers without even trying. And we'll accomplish this simple but surprising feat by not paying the "pros" management fees for their non-market beating performance

And that's attributable to two fundamental factors: (1) professional money managers charge fees which properly need to be subtracted from the portfolio's overall performance when calculating the individual investor's rate of return and (2) stocks are winners over time compared to all other forms of investment.

So all we need to do to "beat the pros" is buy and hold the shares of solid companies (as long as they stay solid companies), and not get caught up in the evening news or daily gyrations of the stock market.

In essence, we can just let "Mr. Market" be our investment manager over the long haul.

He won't charge us commissions or fees and as a result, over time he will make sure that we outperform the "pros."